MF Global bankruptcy shows regulatory resolve

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Nov. 1 (Thomson Reuters Accelus) - The collapse of MF Global Holdings is the first major U.S. financial bankruptcy since new Dodd-Frank insolvency laws ended the doctrine of “too big to fail,” as well as being the first U.S. failure attributable to the Euro crisis. While the collapse is expected to be handled under pre-Dodd Frank bankruptcy laws and under the Securities Investor Protection Corp., it may signal that regulators are prepared to take earlier action when they see uncovered financial risks.

The default follows agreement last week by EU heads of state, which required banks to increase capital by 106 billion euros to restore confidence. This is based on a higher capital ratio of 9 percent of highest quality capital, after a buffer for the mark-down of sovereign debt value of periphery EU States to current market values. Banks and private sector creditors to Greece accepted 50 percent voluntary write-down, as part of the package.

The Dodd-Frank Act introduced systemic risk regulation and resolution authority for the largest groups, in an effort to end the concept of too-big-to-fail firms. However, many commentators and rating agencies still expect authorities to support a highly-systemic firm if it could not be quickly resolved, and the resulting default would be highly disruptive or contagious to consumers or markets.

But MF Global, whose bankruptcy filing on Monday in New York listed assets of $41 billion and liabilities of $39 billion, is unlikely to have been viewed as systemic, or too-big-to-fail, by the US regulators under the law. Indeed the expected sale of the firm’s assets, including to its larger competitors, may increase the size of existing systemic firms.

MF’s assets are below the level that would qualify it as systemic under newly adopted Federal Reserve rules, which use a $50 billion benchmark. Even above this size, designation for non-banks is not automatic, as it first requires evaluation of other factors such as group interconnectedness, and must then be verified a vote of the Financial Stability Oversight Council (FSOC).

Only if the firm had been deemed systemic, would the Fed have been given the prudential oversight of the overall group. The Federal Deposit Insurance Corp.’s role for such a firm is to manage the resolution process. As MF Global did not have a deposit-taking US bank, its main regulators are the Securities and Exchange Commission and the Commodity Futures Trading Commission, which supervised its regulated broker dealer, MF Global Inc. (MFGI).

In addition to having conduct rules, SEC and CFTC also serve as prudential regulators of broker dealers, who are subject to detailed financial rules. Indeed, MF Global claimed that it was regulatory action by the supervisors that helped initiate the bankruptcy filing.

An MF Global executive said in the firm’s bankruptcy filing that the SEC and CFTC had “expressed their grave concerns about MFGI’s viability and whether it should continue operations in the ordinary course.” The chapter 11 filings were made to preserve assets when “no viable alternative was available in the limited time leading up to the regulators’ deadline.”

The company had earlier stated in a September 1 SEC filing that FINRA required it to change the capital treatment of its repurchase transactions on European sovereign debt held by its broker dealer subsidiary. This caused the firm to increase its net capital above that required by SEC Rule 15c3-1 and the early-warning notification level of the Financial Industry Regulatory Authority. (As a broker-dealer, the firm is subject to FINRA as well as SEC rules).

The SEC net capital rules for broker-dealers are focused on market risk, credit risk and liquidity on traded assets. They are very different to the rules applied by the Federal Reserve to banks. Banks are subject to a minimum 8 percent solvency standard, as established in the international Basel Accord, and which have been adopted by bank regulators in major countries, and recently been updated as Basel III.

SEC broker-dealer rules are generally only applied to the stand-alone broker-dealer regulated entity. By contrast, the Fed’s rules also applied to the group to which the bank belongs, through the consolidated regulation of the bank holding company. The inability of the SEC to oversee the full group may have been behind the request to move more capital into the regulated entity.

Given the conversion of several large broker-dealers to bank holding company status in the 2008 crisis, all major dealers are now subject to group-wide financial supervision by the Fed under Basel standards. As MF did not have such a status, it was instead subject to the SEC rules. The regulator was criticized for failing to act earlier to limit the business of Lehman for not having enough capital before its default.

On Monday, the NY Fed also suspended MF Global’s broker dealer from further dealings as a primary dealer. The firm had only recently been admitted to this status, which was part of the NY Fed’s move to expand the range of repo counterparties with which it deals directly.

Liquidation proceedings were also filled by the SIPC, the guarantee scheme for broker dealers. This will enable customers of MF Global Inc. to collect securities in their name at the firm. Funds from SIPC are also available to satisfy any remaining claims of each customer up to $500,000. A trustee has been named that will contact the firm’s clients.

“When the customers of a failed SIPC member brokerage firm have left their securities in the custody of that firm, SIPC acts as quickly as possible to protect those customers,” said Orlan Johnson, SIPC board chairman. “In this case, SIPC initiated the liquidation proceeding within hours of being notified by the SEC that a SIPC case was necessary to protect the investing public.”